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This theory of asserting taxing authority may be adopted by more states, especially if it continues to prevail against constitutional challenges.

Many taxpayers and their advisers love to play in the gray areas of the law, push the envelope, find that loophole. Others want black-and-white rules, certainty, and bright-line tests. For those latter taxpayers, and for state taxing authorities, the Multistate Tax Commission (MTC) developed the concept of "factor presence nexus" in October 2002. It was stated at the time to be "a simple, certain and equitable standard for the collection of state business activity taxes."

Fast-forward to November 2016. The Ohio Supreme Court just issued its decision in Crutchfield Corp. v. Testa, No. 2016-Ohio-7760 (Ohio 11/17/16), upholding the constitutionality of the factor presence nexus standard in Ohio's commercial activity tax. This is the highest-level court to rule on the issue to date. Before examining the court's decision and the potential ramifications for factor presence nexus standards across the country, let's first examine the developments that led to it.

WHAT LED TO FACTOR PRESENCE NEXUS?

In 2002, the MTC created a uniform proposed law that states could adopt, as is or with modifications, to provide bright-line standards for when a nondomiciled business entity has nexus for business activity taxes in a state. For sales and use taxes, which are transactional taxes, the U.S. Supreme Court has ruled in National Bellas Hess, Inc.v. Department of Rev., 386 U.S. 753 (1967), and QuillCorp. v. North Dakota, 504 U.S. 298 (1992), that physical presence is required to create nexus.

No such standard exists for business activity taxes such as income tax, franchise tax, or gross-receipts tax. Instead, some states employ the concept of economic nexus to justify subjecting a business to a business activity tax, meaning no physical presence is required, just that the business is exploiting the state's market.

The economic nexus concept can create much uncertainty because it relies on facts and circumstances, and definitions of subjective terms such as "doing business in," "deriving income from," and "actively solicits." Intelligent professionals can easily disagree about terms like these, but it was recognized that people can't really disagree about something such as "a dollar amount of $500,000 of sales." Thus, the MTC's uniform proposed law states that substantial nexus is established if any of the following thresholds is exceeded during the tax period:

$50,000 of property;

$50,000 of payroll;

$500,000 of sales; or

25% of total property, total payroll, or total sales.

Of these factors, the property and payroll factors would indicate a physical presence regardless, so the real heart of the matter for factor presence nexus is the sales factor. Since the MTC issued the substantial nexus standard in October 2002, nine states have adopted some form of a sales factor presence nexus standard. Ohio was the first state to do so. The other states that have adopted some form of a sales factor presence nexus standard are Alabama, California, Colorado, Connecticut, Michigan, New York, Tennessee, and Virginia. The question then becomes: Is nexus any clearer in these states as a result of the factor presence nexus standard? Let's look at a few examples.

FACTOR PRESENCE STANDARDS

Michigan has adopted a $350,000 sales threshold, first for the Michigan Business Tax and now for its corporate income tax. This is an easy measurement, which, when combined with market-based sourcing of services (i.e., sourcing services where the benefit is received for apportionment purposes), should provide a bright-line test for economic nexus. (Note that for Michigan and all other states with a net income tax, the protections of the Interstate Income Act, P.L. 86-272, for sellers of tangible personal property still exist; that is, factor presence nexus standards are trumped by P.L. 86-272, which does not allow states to impose income tax on out-of-state businesses whose in-state activities are limited to solicitation of orders for sales of tangible personal property and delivery of the property if the orders are sent outside of the state for approval and fulfillment.) However, Michigan's law says that nexus exists if the $350,000 threshold is met and the taxpayer actively solicits in the state.

As proof that this "actively solicits" requirement causes problems, consider that even though the statute then goes on to define "actively solicits," the Michigan Department of Treasury still found the need to issue the seven-page Revenue Administrative Bulletin 2013-9 to answer the one question: "What does it mean to 'actively solicit' sales in this state for purposes of [Michigan Compiled Laws] 206.621?" In terms of bright-line standards that are simple, certain, and equitable, Michigan's use of factor presence should probably be considered a failure.

Colorado has adopted the previously defined MTC thresholds as is, so it should be reasonably simple to determine whether a business has nexus and a filing requirement for income tax. The wrinkle here is that, while Colorado still uses cost-of-performance sourcing for sales of services for apportionment purposes (apportioning services based on where the service activity was performed), it has adopted the MTC's proposed market-based sourcing for sales of services for determining whether the sales factor presence threshold is met.

That means that a business has to source its Colorado sales under both methods, and a nondomiciled business could end up exceeding the sales factor threshold for nexus and filing purposes but have a zero apportionment factor for tax calculation purposes. Since there is no minimum tax or equity-based franchise tax, corporations may have to file returns with no income in Colorado simply as a result of the state's adoption of the MTC's factor presence nexus thresholds.

California has also adopted the previously mentioned MTC thresholds and has indexed them for inflation. Also, it applies market-based sourcing of services for apportionment purposes, so this could be a state where the goals of "simple, certain, and equitable" have been achieved. But shortly after California adopted the MTC thresholds, it issued California Franchise Tax Board Notice No. 2011-06 to affirmatively state that "when the entity does not meet one or more of those conditions [the MTC thresholds], it still must determine whether it was 'actively engaging in any transaction for the purpose of financial or pecuniary gain or profit' under the general rule for 'doing business' found within [California Revenue & Taxation Code] Section 23101, subdivision (a)."

In other words, the California factor presence thresholds still do not provide absolute certainty because they do not act as a safe harbor under which nexus is not created, but just as an alternative test over which nexus is definitely created. It should be noted that while other states may also view the thresholds as an alternative test instead of as a safe harbor, California is the only one known to explicitly state this position.

It appears that factor presence nexus, instead of making nexus determinations "simple, certain, and equitable," has (1) created another nexus test in addition to a facts-and-circumstances "doing business" economic presence test; (2) caused taxpayers to have to determine sourcing of services under multiple methods; and (3) resulted in needless filing of corporate income tax returns. Is there any state where factor presence has worked well? Yes: Ohio.

OHIO'S COMMERCIAL ACTIVITY TAX

Ohio's commercial activity tax (CAT) is a franchise tax on the privilege of doing business, measured by gross receipts. It does not have the P.L. 86-272 problems, does not have apportionment formula issues to contend with, and uses market-based sourcing for services. Even better, the Ohio Department of Taxation has stated that a nondomiciled business is only required to register and pay the CAT if it has a bright-line presence in Ohio.

Let's return to Crutchfield. If Ohio's CAT works so well regarding factor presence nexus, then what was Crutchfield's problem with it? Crutchfield is a catalog- and internet-based seller of consumer electronic products (TVs, stereos, cameras, etc.). It is based in Virginia and has no physical presence in Ohio. Therefore, without the factor presence nexus standard, Crutchfield would not be subject to the CAT (there never was a facts-and-circumstances economic nexus standard for the CAT, as it originated in 2005 and was written directly with the factor presence standard). Crutchfield attacked perceived issues with the statute itself and claimed that the law was unconstitutional because it exceeded the physical presence nexus standard.

The Ohio Supreme Court held that the CAT is a constitutionally allowed tax. It said that the U.S. Supreme Court's ruling in Quill requiring physical presence to satisfy the Due Process and Commerce clauses of the U.S. Constitution does not apply to a business privilege tax, only to a transactional tax. The court held this to be true "as long as the privilege tax is imposed with an adequate quantitative standard that ensures that the taxpayer's nexus with the state is substantial."

This qualifying phrase is important because it deals with the Commerce Clause's "substantial nexus" requirement. The MTC's factor presence language, which was effectively adopted by Ohio, considers it a foregone conclusion that the thresholds included in the proposed law will result in substantial nexus for a business.

The Ohio Supreme Court held, with virtually no analysis, that the $500,000 sales factor threshold was "an adequate quantitative standard" to uphold the CAT as a constitutionally allowed tax. The court acknowledged that the $500,000 figure was arbitrary, but essentially said that any established threshold would be arbitrary, and this one was high enough so that the burdens on interstate commerce were not clearly excessive.

LOOKING FORWARD

With the Ohio Supreme Court holding the CAT to be constitutional, what is the future of factor presence nexus standards? No other factor presence nexus cases have risen to the level of a state supreme court—meaning there is no split among state courts—and the U.S. Supreme Court is generally reluctant to hear state tax nexus cases. So it is unlikely that the issue will get resolved on a national level. Instead, states may have been waiting for a constitutional challenge to provide comfort to them that enacting such a standard is unlikely to be overturned. They now have their signal to proceed down this path.

What this means for taxpayers, unfortunately, is that states now have one more arrow in their quiver to use to subject businesses to tax. No longer do they have to rely on physical presence or messy facts-and-circumstances economic nexus tests; now they can set an arbitrary sales factor threshold and use that to claim nexus. Taxpayers, on the flip side, won't always be able to use those thresholds as protection from a nexus determination. In other words, factor presence nexus standards might turn into a nationwide coin toss by the states, which will be able to say to taxpayers: "Heads we win, tails you lose."

About the author

Michael Bannasch (Michael.Bannasch@rehmann.com) is a senior manager in the State and Local Tax practice of Rehmann CPAs in Ann Arbor, Mich. He has a Master of Science in Taxation from Grand Valley State University in Allendale, Mich.

To comment on this article or to suggest an idea for another article, contact Sally P. Schreiber, senior editor, at Sally.Schreiber@aicpa-cima.com or 919-402-4828.

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